IR43 29 November 1994 TAXATION OF LIFE ASSURANCE COMPANIES The Chancellor proposes in his Budget to make a number of changes to the way in which insurance companies are taxed on their life assurance business. The Chancellor's intention is to remedy difficulties and anomalies in the existing special rules for taxing life insurance companies which have been identified in the course of a review of those existing rules. The industry's representative bodies have made a valuable input to this review. All the measures, apart from that relating to business done through overseas branches which takes effect from today, come into effect for accounting periods beginning after 31 December 1994. DETAILS 1. The measures changing the tax rules for life insurancecompanies will: allow annuities and some interest to be deducted when it is necessary to measure the trading profits of a life insurance business; prevent a loss being used more than once; amend the way income and gains are attributed to different classes of business to minimise the distortions which can occur when a company changes its valuation basis; and to ensure a closer fit with commercial reality; make it clear when capital allowances are available; introduce other minor measures relating to dividends and distributions adapting existing legislation to the circumstances of life assurance companies; prevent United Kingdom residents taking advantage of the tax treatment given to business written at overseas branches with non- residents. Case I of Schedule D profits: Annuities and annual interest 2. Companies generally cannot deduct annuity payments or some types of annual interest in arriving at their Schedule D Case I trading profit for tax purposes. Instead these are deducted as what are known as "charges on income" in computing the total income and gains chargeable to corporation tax. This rule works in an unfair and unintended way for life insurance companies. For some of them it can result in a much larger than intended proportion of profits being charged at the normal corporation tax rate of 33 per cent rather than the special 25 per cent rate that applies to the profits accruing for policyholders. Other companies have found that the rule gives them a unintended advantage. The Chancellor proposes to allow these charges to be deducted in arriving at a life insurance company's trading profits so that the calculation represents as closely as possible the commercial profit from operating the business. Double relief for losses 3. If a life insurance company has a trading loss computed in accordance with the rules of Case I of Schedule D it may claim to set that loss against other profits or surrender it as group relief to another group company. At the same time as calculating such a Case I loss on its business as a whole, it may also incur a loss on individual parts of its business, such as its pension business or its overseas life assurance business. These losses are a constituent part of the overall Case I loss, and in some cases can represent the whole loss. The current rules allow a pension or overseas life assurance business loss to be carried forward against future profits. The Chancellor proposes to end the scope for double relief for the same loss. Pension business and overseas life assurance business: calculation of investment return 4. Where an insurance company writes more than one kind of business within the same fund, it is necessary to apportion the total investment return arising in the fund between the different kinds. Where some at least of the business in the fund is "participating business", where policyholder bonuses are declared out of profits, the mechanism for making the apportionment normally splits the return in the fund in the same ratio as bonuses are paid or declared. However, in some cases where a substantial amount of non-participating business is written in a fund that also contains participating business, the split by reference to bonuses can underestimate the return to the non- participating business. There is therefore a further mechanism, which has come to be known as the "floor", which allocates the investment return according to the ratio of the company's liabilities to different classes of policyholder and which applies where it gives a greater figure than the bonus based split. 5. If a company changes the way it calculates its liabilities to its policyholders the "floor" mechanism can sometimes result in a company's profit from, for example, pension business substantially exceeding the overall profit from the whole business. This was not intended and the Chancellor proposes to amend the way the "floor" operates so as to alleviate this effect by providing that a company may set off the amounts by which the bonus method calculation has exceeded the "floor" method calculation in previous years against the "floor" method calculation in a year in which the "floor" applies. Apportionment of Income Rules 6. A life insurance company may have a number of different types of business each of which has its own tax rules. But it will usually have only one fund of assets backing these different types of business. Rules are needed to determine how much of the income or gains from any asset is referable to a particular class of business. 7. The existing rules treat assets which back investment linked business (that is business where the sum payable to the policyholder is calculated by reference to the value of particular assets) as referable to the class of business concerned. But at present this rule only applies where there is only one class of business to which a particular asset is linked. In many cases the asset may be linked to more than one class and where this is the case the existing rules can lead to unexpected distortions. The Chancellor proposes to amend these rules to allow the assets to be notionally split between the classes of business in the proportion that the value of the underlying liabilities of each type of business bears to the whole. And where assets back linked business of a particular kind and the contract also provides for a small amount of other non- linked business such as permanent health insurance, the presence of this other business will not prevent the assets being treated as linked solely to the predominant linked business. 8. In addition, the current apportionment rules may require a life assurance company with overseas branch business to compute the precise amount of capital gains arising on those assets even though the gains are exempt from tax. The Chancellor proposes to remove the requirement to make these often complicated computations. This will be a useful deregulatory measure for the companies concerned. Capital Allowances 9. The statutory foundation for giving capital allowances to life assurance companies on assets they hold as investments is unclear. The Chancellor proposes to take the opportunity to make it clear in what circumstances a life assurance company can receive such capital allowances. At the same time, capital allowances on assets used in the management of the business will, like expenses of management generally, be allocated to the class of business to which they relate. Dividend and distribution measures 10. Like all companies a life assurance company can set management expenses in excess of its income against dividend income from United Kingdom shares and obtain payment of the tax credits attaching to those dividends at the current rate of 20 per cent. However, this relief may be recouped if in a subsequent year the company is required to account for advance corporation tax (ACT) on dividends it pays after setting off dividends it receives when calculating its ACT liability. The tax credits paid are clawed back by a pound for pound restriction of the ACT the company can set off against its corporation tax. But the expenses previously used to claim relief are restored to it so that the company is back in the position it would have been if it had never claimed. 11. This reversing mechanism works as intended for most companies but can cause distortions for life assurance companies which are not allowed to set off all the dividends they received when calculating the ACT they have to pay. They may find that the restriction in setting off ACT applies but that the expenses are not restored. The Chancellor proposes a minor amendment that will restore the expenses where there is an ACT restriction. 12. The Chancellor also proposes to allow life assurance companies to claim repayment interest on overpaid ACT (life assurance companies are unique in having potential overpaid ACT months or years after the end of an accounting period) and to ensure that the Foreign Income Dividend scheme introduced last year works correctly where an overseas life insurance company receives such dividends. Overseas life assurance business 13. On 31 October, the Financial Secretary to the Treasury announced, in answer to a written Parliamentary Question, that life assurance companies would in future receive the same favourable tax treatment for business sold directly from the United Kingdom to European residents as that given to business sold from overseas branches. But to ensure that United Kingdom residents do not take advantage of this favourable tax treatment, the new rules will only apply where the beneficial owner of the policy is an individual or employer resident in the state concerned. This restriction will also apply to overseas branch contracts made on or after today. NOTES FOR EDITORS 1. The changes to overseas life assurance business were publicised in an Inland Revenue Press Release issued on 31 October 1994. 2. Details of the major changes to the tax rules for life assurance announced in 1989, 1990 and 1991 were included in Inland Revenue Press Releases of 14 March 1989 ("New Rules for Taxing Life Assurance"), 20 December 1989 ("Life Assurance: Further Details of the Tax Rules from 1990 Onwards"), 20 March 1990 ("Life Assurance Tax Proposals") and 19 March 1991 ("Life Assurance Tax Proposals"). 3. These changes come as a result of a review of the earlier reforms which the Inland Revenue have been conducting, with assistance from the representative bodies of the industry.